Zero : A Theoretical Overview

Abstract

This term paper looks at work done by different eminent researchers towards the understanding of zero – as a price and as a probability, along with our perception of zero. The concept is looked at both from an economic point of view and from a psychological angle. Theories proposed to adjust the standard economic model to better reflect human behaviour and bounded rationality, found experimentally, are also discussed. The mentioned experiments can be repeated on different demographic sections with interesting results, and remain a point of further study. The emergence of neuroeconomics to fill gaps in standard economics theory has also been explored.

Readings

Readings for this theoretical overview include the following works:

Paper/Book Author Date
Zero As a Special Price - True Value for Free Products Dan Ariely, Kristina Shampanier 2007
Predictably Irrational Dan Ariely 2008
Thinking Fast and Thinking Slow Daniel Kahneman 2011
Prospect Theory : An Analysis of Decision under Risk Kahneman, Tversky 1979
Freakonomics Steven D. Levitt 2005
Effort for Payment : A Tale of Two Markets Heyman and Ariely 2004

Context

The standard economic theory aims to explain macroeconomic and microeconomic observations of the world, looking into financial decisions that we make, and the implications of our decisions on larger market forces. It also attempts to theoretically deconstruct these market forces and understand their base causes.

In Steven D. Levitt’s words, Economics can be be described as ‘a study of incentives’. This definition inherently puts economics under a cognitive lens, with the study of human behaviour gaining utmost importance, in both microeconomic and macroeconomic contexts. Yet, bizarrely enough, standard economic theory assumes humans to be perfectly rational beings, with all decisions being taken by humans under perfect or imperfect information conditions, presumed to be perfectly rational.

This stance of standard economic theory started being questioned in the early 1970s with the rise of psychological economists of the likes of Daniel Kahneman and Amos Tversky. Questions were raised on the presumed rationality of humans in financial decision making, and a series of controlled experimentation clearly showed deviations from the standard economic theory. These experimentations and proposed models for human behaviour that could better explain human irrationality in financial decisions were clubbed under the domain of a new and upcoming field – Behavioral Economics.

Besides active work in Behavioral Economics over the past few decades, the development of a much more focused sub-domain – Neuroeconomics – has been notable. Neuroeconomics looks at financial decision making from a cognitive neuroscience perspective, evaluating experimentally observed bounded rationality of humans, based on literature available in neuroscience.

Now that we have a contextual understanding of the domain, let’s look at work done in neuroeconomics on the concept of zero.

Literature Overview

Daniel Kahneman won the Nobel prize in Economics, in 2002 for his and Amos Tversky’s work on Prospect Theory (1979). A notable point here is that Kahneman never took a course in Economics throughout his academic career. Their paper published in 1979, among other things, also looked at the irrational behaviour people exhibit when comparing zero and near-zero probabilities.

As put in words by Dan Ariely, “Kahneman and Tversky’s (1979) work on probabilities indicates that when it comes to gambles, people perceive zero probability (and certainty) substantially differently than they do small positive probabilities. That is, whereas the values of the latter are perceived as higher than they actually are, perceptions of zero probability are accurate.”

In Daniel Kahneman’s ‘Thinking Fast and Thinking Slow’ he talks about two systems behind our cognitive decision making – System 1 and System 2. System 2 is the logical decision making that we do while being conscious of the process, like how you (the reader) are reading this document and understanding words and context; whereas System 1 is the force behind our intuitions – like why you (the reader) may not like this font, you did not consciously weigh the pros and cons of the font before making the decision, that’s how System 1 works, without our conscious focus.
Now here, the proposition is that System 1 is responsible for the ‘irrational’ prejudice that we have for near-zero probabilities, a more detailed explanation is available in discussions ahead.

Another important point in our understanding of Zero is the context in which it is perceived. In Chicago Booth School economist Steven D. Levitt’s 2005 bestseller ‘Freakonomics’ he highlighted the differences between Market Norms and Social Norms. We follow market norms when we value things in a financial manner, whereas social norms are followed in decisions where there’s an absence of financial context – such as appreciation for home-cooked food. Levitt’s work on Market and Social norms was reiterated in Heyman and Ariely’s ‘Effort for Payment : A Tale of Two Markets’. With certain deviations from standard economic theory when dealing with Zero, explained in a social context. For example, when a class of students were asked to take chocolates, the demand was higher when the chocolates were priced, compared to when the chocolates were free. This economic abnormality can be explained by the theory on social norms, where free chocolates weren’t perceived as an economic transaction.

In ‘Zero As a Special Price - True Value for Free Products’, Dan Ariely and Kristina Shampanier attempt to sum up existing theories on abnormalities regarding zero from an economic context while relying on experimentation to validate their hypothesis. Standard economic theory says that when faced with a choice of selecting one of several available products (or possibly buying nothing), people will choose the option with the highest cost–benefit difference. But in this paper, Dan Ariely and Kristina Shampanier propose that decisions about free products differ as people do not simply subtract costs from benefits and perceive the benefits associated with free products as higher.

To test this radical proposal, a series of experiments were carried out while contrasting demand for two products across conditions where they maintained a constant price difference between goods, but varied the said prices such that the cheaper product in the set of products is priced at either a low positive or a zero price. The results showed a skewed demand for zero-priced products which were against the prediction of standard economic theory, and confirmed the hypothesis put forward in the paper. Thus, people appear to act as if zero pricing of a good not only decreases its cost but also adds to its benefits. These tests were both real and hypothetical in nature, and carried out on campus residents of MIT, Cambridge.

Beyond this effect, several psychological antecedents of the effect were proposed as well, including social norms, mapping difficulty among others. More details on the saime are discussed in the Discussion section below.

Discussion

Based on existing literature on the subject, we can say with a fair degree of confidence that humans aren’t perfectly rational. Prospect theory among other popular works have firmly established the bounded and contextual nature of human rationality when it comes to decision making. Taking up the study of economic theory abnormalities surrounding ‘Zero’ proved to be an excellent way to gauge various sub-domains of Behavioural Economics, and by extent human behaviour and our cognitive structure.

Zero being perceived as a ‘social norm’ in contextual decisions highlights how our ‘System 1’ functions, and how quickly our brain is able to differentiate a financial context from a non-financial one without us being consciously aware of it. The way our brain seems to be hot-wired from birth to gauge patterns in certain respects, such as language, reading facial expressions, understanding social contexts is fascinating to say the least. These functionalities of ‘System 1’ as put by Daniel Kahneman, are built out of synaptic networks that comprise Associative Memory and is incredibly powerful and engagingly interesting.

It is this ‘System 1’ that give chess masters an instinctive responses to different board positions, where others will use their logical, conscious thought process. Our perception of near-zero probability and zero costs eventually boils down to this ‘System 1’ only. This rapid-decision-making functionality has been honed throughout human evolution to ensure our survival, and that involves quick decision making in situations, without a logical evaluation, when the context of the decision seems familiar. Hence, when someone gives us something for ‘free’, taking it is the instinctive reaction. It’s a risk-free decision, that on face-value and past context seems intuitive.

The study of how our instincts are honed, and how our brain actually functions in intuitive decision-making, while studying our understanding of ‘Zero’ has been a thought provoking venture.

Future Scope

Although the work done by the academic community in Behavioural Economics and intuitive decision making has been phenomenal, there is still scope for further refinement and verification of concepts concerning our understanding of ‘Zero’ price and probability. Some points that I feel future studies can be built around are as follows:

  • Looking at a younger demographic might help researchers understand some of the characteristics of intuition and help segregate environmental factors and learnt behaviour from evolutionary traits.
  • Although microscopic transactions have been well-explored, work still needs to be done at the macroscopic level, explaining market forces from a neuroscience perspective still remain the holy grail of behavioural economics.

References

  1. Ariely, Dan. Predictably Irrational : the Hidden Forces That Shape Our Decisions. New York :Harper Perennial, 2010. Print.
  2. Ariely, Dan & Shampanier, Kristina. Zero As a Special Price, http://web.mit.edu/ariely/www/MIT/Papers/zero.pdf
  3. Heyman, James & Ariely, Dan. (2004). Effort for Payment A Tale of Two Markets. Psychological science. 15. 787-93. 10.1111/j.0956-7976.2004.00757.x.
  4. Kahneman, Daniel, 1934-. Thinking, Fast and Slow. New York :Farrar, Straus and Giroux, 2011. Print.
  5. Kahneman, Daniel & Tversky, Amos, 1979. “Prospect Theory: An Analysis of Decision under Risk,” Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
  6. Levitt, Steven D, and Stephen J. Dubner. Freakonomics: A Rogue Economist Explores the Hidden Side of Everything. New York: William Morrow, 2005. Print.

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